Session 1Framework for financial statement analysis: Statutory financial reports, disclosure quality, sources of financial information, segment reporting and analysis.Case: Analysis of segment data for Lucent and Roche. *12/06/2015

Financial Statements Reflect Business Activities*

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Financial Statements*12/06/2015

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Additional Information(Beyond Financial Statements)Managements Discussion & Analysis (MD&A)Auditor ReportNotes to AccountsSupplementary Information

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Financial Statement AnalysisEvaluation of risk and return (and Growth) is the major objective of financial statement analysis.Evaluation, projection and estimation of earnings is crucial for valuation.

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Cross-sectional analysis of financial statement informationFinancial statement data are often used in a comparative mode i.e.Cross-sectional applications: comparison of one entity with other entities at the same point in time.Time series applications: comparison of one entity at different points in time.

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Analysts pointAnalysis of companies with more than one line of business has inherent difficulties as compared with the analysis of companies engaged in a single business.Decision making for allocation of resources in firms with multiple line of business warrants detailed analysis of business segments. *12/06/2015

Challenges of Diversified Companies (DCs)DCs operate in multiple segments.Each segment or division exhibit varying rates of profitability, risk and growth opportunities.Varying asset composition and financing mix.Interest groups wants to know segment that is providing cash and using cash.Research suggest that income forecasting based on forecasting from segment income is more rational and accurate.*12/06/2015

Rationale

Segment information helps users of financial statements:(a) To better understand the performance of the enterprise;(b) To better assess the risks and returns of the enterprise (including growth); and(c) To make more informed judgments about the enterprise as a whole.*12/06/2015

A: Recognition of Reportable Segments*IAS-14 does not require the reporting firm to provide information for every business segment. Firms are required to present information for reportable segments only. A business or geographical segment should be identified as a reportable segment on the following basis:Turnover- A Segment whose revenue is 10% or more of the total revenue of all segments (i.e. external + internal before elimination of intersegment sales). Profit or Loss- Its segment result, whether profit or loss is 10% or more of the combined result of all segments in profit. the combined result of all segments in loss Assets-If segment assets are 10% or more of the assets of all segments taken together.12/06/2015

Recognition of Reportable Segments4. Opinion of the Management-The management may use discretion in pointing out any segment as a reportable segment irrespective of magnitude. 5. 75% of total enterprise revenue- If the external revenue attributable to reportable segments constitutes less than 75% of the total revenue of the enterprise, additional segments should be identified as reportable segments, even if they do not meet the 10% threshold in terms of revenue or assets or result, until at least 75% of total enterprise revenue is included in reportable segments.

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ImplicationIf a company derives 10% or more of revenues from sales to a single customer, revenues from this customer must be reported. Note that name of the major customer need not be disclosed, only the amount of sales.*12/06/2015

*Example: 1The following is the detail of the Hypothetical Ltd. All figures are in Rs. Crores.12/06/2015

SegmentsABCDETotalSegment TotalEnterprise1. Segment revenue External sales2003001006040700 Internal sales1006040200Total Revenue30036014060409007002. Segment result Profit/Loss080-2015580803. Segment assets5010030155200

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Example-2Refer the Excel Sheet: Analysis 2 and 2E*12/06/2015

ImplicationA segment recognized as reportable segment in the immediate preceding period should continue to be a reportable segment during the present reporting period even if it does not meet the 10% criteria. New segment reported in the current period based on 10% criteria preceding year segment information for the same must be shown even if it does not fulfill 10% criteria.*12/06/2015

International Practice (Disclosure)IAS 14 stipulates that an enterprise should disclose the following for each primary reportable segmentSegment revenueSegment resultTotal carrying amount of segment assetsTotal amount of segment liabilitiesTotal capital expenditure incurred during the periodDepreciation and amortization in respect of segment assets.Total amount of significant non-cash expenses, other than depreciation and amortization.Income Tax Expenses

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B:AS-17 on Segment Reporting in India

*Accounting Standard (AS) 17, Segment Reporting, issued by the Council of the Institute of Chartered Accountants of India, comes into effect in respect of accounting periods commencing on or after 1.4.2001.This Standard is mandatory in nature in respect of accounting periods commencing on or after 1-4-2004. AS-17 mandates companies to provide some minimum segmental information. This includes information relating to segmental assets, liabilities, income, expenses, profits or losses and accounting policies. 12/06/2015

Applicability of AS-17Comes into effect in 1.4.2001Firms Debt or equity securities are listed on a stock exchange in India.Firms are in process of issuing equity or debt securities that will be listed in any recognized exchanges in India as evidenced from board resolution.All other commercial or business enterprises whose turnover for the accounting period exceeds Rs.50 Crore.*12/06/2015

Why Segment ReportingInformation about different types of products, services, markets of an enterprise and its operations in different geographical areas - often called segment information - is relevant to assessing the risks and returns of a diversified or multi-locational enterprise but may not be determinable from the aggregated data. Therefore, reporting of segment information is widely regarded as necessary for meeting the needs of users of financial statements.

*Note: Accounting Standards: IAS -14 , AS-17, IFRS 8 SFAS 13112/06/2015

Why Segment ReportingPart of the overall problem of external financial reporting for diversified firms concerns the degree to which disclosure on a segmented basis aids the financial analyst or investor in making knowledgeable investment recommendations and financial commitments. Theoretically, segmented income statement and balance sheet data should enable the analyst-investor to analyze more precisely the component parts of the total firm and thereby evaluate the firm's stock on a more rational basis.

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Why Segment Reporting*Pragmatically, financial analysts have argued that different rates of growth, profitability, and risk among divisions of diversified firms complicate the task of evaluating earnings prospects and therefore necessitate the disclosure of sub-entity information.Segment information is helpful in evaluating the risks and returns.12/06/2015

ImplicationSegmental reporting is a transition from quantitative to qualitative disclosures. Revenues, expenses, profits, assets, liabilities, cash flows, etc., classified by segments would help investors and creditors to identify the major sources of strengths of the firm and risk factors. The increased reliability of the data reduces the risk-perception levels and consequent risk premium expectations.

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Application* This Statement should be applied in presenting general purpose financial statements.The requirements of this Statement are also applicable in case of consolidated financial statements.An enterprise should comply with the requirements of this Statement fully and not selectively.12/06/2015

Usefulness First, if segmented financial reports enable the investor to analyze more precisely the separate earnings prospects of the conglomerate's component parts and thereby arrive at a more informed approximation of future total firm income, then current estimates of future earnings are more likely to approximate actual results. Second, if segmental disclosure does provide a more objective basis for evaluating the future earnings performance of a diversified firm and thereby currently valuing the firm's stock in line with these expectations, then stock price fluctuations due to investor ignorance should be lessened and therefore price dispersion should be narrowed over time.'

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UsefulnessAn initial proposition is that segmental disclosure contains informational content for investors regarding future earnings changes of a firm. Under segment reporting, profitable or unprofitable divisions can be examined individually, and a more informed decision can be made regarding the future earnings performance of the firm as a whole.

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Segment revenue*Segment revenue is the aggregate of (i) the portion of enterprise revenue that is directly attributable to a segment,(ii) the relevant portion of enterprise revenue that can be allocated on a reasonable basis to a segment, and(iii) revenue from transactions with other segments of the enterprise.

Segment revenue does not include:(a) extraordinary items as defined in AS 5, Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies;(b) interest or dividend income, including interest earned on advances or loans to other segments unless the operations of the segment are primarily of a financial nature; and(c) gains on sales of investments or on extinguishment of debt unless the operations of the segment are primarily of a financial nature.12/06/2015

C: Types of segments*Accounting Standard (AS) 17 (issued 2000)-Segment Reporting classifies segments into business segments and geographical segments:A business segment is a distinguishable component of an enterprise that is engaged in providing an individual product or service or a group of related products or services and that is subject to risks and returns that are different from those of other business segments.A geographical segment is a distinguishable component of an enterprise that is engaged in providing products or services within a particular economic environment and that is subject to risks and returns that are different from those of components operating in other economic environments.Note: Line-of-business- approachNote: IAS 14 also classifies segments into (a) Business segment (b) Geographical segment.

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PracticeManagement judgment guided by factors for reporting segments of business:ProductsProduction ProcessMarkets or Marketing methods

Note: These guidelines led to a Line of business approach to segment disclosure.*12/06/2015

1. Business SegmentIdentification factors for business segment are:The nature of the products or services Nature of the production processesType or class of customers for the products or servicesMethods used to distribute the products or provide the servicesIf applicable the nature of the regulatory environment, for example, banking, insurance or public utilities.*12/06/2015

ImplicationA business segment should not include products and services that are significantly different from each other in terms of risks and returns. Products and services that are similar in some respects but are different with respect to several of the other factors should not be included in the same segments. For Example: risk and return of the shipping business of L& T are different from its Engineering business.Note: Application of the principles stipulated in IAS-14 is a matter of judgment. For example , whether passenger car and commercial vehicle are different in terms of risks and returns is a matter of judgment.*12/06/2015

2. Geographical Segment (GS)Economic environment in which the firm is operating is the identifying basis. Factors that should be considered in identifying geographical segments include:Similarity of political and economic conditionsRelationships between operations in different geographical areasProximity of operationsSpecial risks associated with operations in particular area. The underlying currency risks*12/06/2015

ImplicationGS should be based on either the location of production or service facilities or the location of its customers.One has to make a judgment on whether risks and returns for the segment are different from others.A geographical segment may be single country, a group of two or more countries or a region within a country.Usually a country is considered as a segment.*12/06/2015

Example: 3*12/06/2015

Name of the CompanyAnnual ReportSegments BS/GS1. Reliance Industries Ltd.2013-2014pp.261-262BS: Petrochemicals, Refining, Oil and Gas, Others (Textile, Retail Business, SEZ Development, Telecom/Broadband business)GS: within India, Outside IndiaNote: RIL reports the segments as Primary and Secondary segment information2. Infosys Technologies Ltd.2013-2014pp.97-98BS: Financial Services and Insurance (FSI), Manufacturing (MFG), Energy, Utilities, Communication and services (ECS), Retail, Consumer packaged goods, and Logistics (RCL, Life sciences and Healthcare (LSH).GS: North America, Europe, India, Rest of the World3. Hero Motocorp2013-2014pp.136.A single primary business segment viz. Two wheelers, its parts and ancillary services and is a single geographical segment.

Business Segments* 12/06/2015

NAME OF THE COMPANYBUSINESS SEGMENTS1. Hindustan Unilever Ltd.Soap and detergents, personal products, beverages, foods, ice creams, exports and others.2. ITC Ltd.FMCG, Cigarettes, hotels, agribusiness, paperboards, paper and packaging.3. Dr. Reddys LabActive pharmaceutical ingredients, formulations, generics, critical care, biotechnology4. HDFC Ltd.Housing finance, insurance, asset management and others5. Mahindra and MahindraAutomotive, farm equipment, IT services, financial services

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Name of the CompanyGeographic segments1. Hindustan Unilever Ltd.India, Outside India2. Ranbaxy labIndia, Europe, Asia pacific, North America, Rest of world3. State Bank of IndiaDomestic operation and foreign operation4. Mahindra & MahindraDomestic and overseas

D: Primary and Secondary Reporting Segments*Business and Geographic segment are classified as primary and secondary reporting segment on the basis of risk and return evaluation. (Example-RIL)The dominant source of enterprises risk and return is identified as primary segment. If the major sources of risk and returns are products, the business segments are regarded as primary segments and geographical segments as secondary segments and vice versa.The standard recommends revenue, results and asset tests to identify reportable segments and a firm can add more segments until 75% of enterprise revenue test is fulfilled.For each segment, segment asset, liabilities, revenue, expenses and profits/losses are to be reported along with the segment-wise policies.12/06/2015

12/06/2015*Reportable segments are categorized in the following two parts, for the purpose of disclosure, namely, primary reportable segment and secondary reportable segment.Basis of Categorization of Reportable segments

SituationsPrimary reportable segmentSecondary reportable segmentProvided that Risks and Returns of an enterprise are primarily affected by variation in product/serviceBusiness SegmentGeographical segment is based on the location of customersIn case risks and returns of an enterprise are primarily affected by its operations in different geographical locationsGeographical segmentBusiness SegmentSupposing risks and returns of an enterprise are mostly affected by both differences in product/services it manufactures and its operations in different geographical locationsBusiness SegmentGeographical segment

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SEBI and AS 17Listed companies must furnish segment wise revenue, results and capital employed along with the quarterly unaudited financial results with effect from quarters ending 30th September 2001. *12/06/2015

2. Hyderabad , R.L. and Kalyanshetti (2011), Segment Reporting Practices in Indian IT Companies, The IUP Journal of Accounting Research & Audit Practices, Vol. X, No. 3, 2011The sample IT companies in the present case fare poorly in providing segmental information. Only 11% of the sample firms comply with the mandatory disclosure norms, which include capital market icons like Infosys and Wipro. Others are yet to view segment reporting seriously. For fear of competitive disadvantage or so, the firms fare poorly even on voluntary disclosures. Even bigger firms are hesitant to disclose extra details relating to the segments.*12/06/2015

ImplicationThe study finds the Indian IT companies to identify a few segments and business segment is the primary segment. Multiple-listed companies identify more segments than single stock exchange listed companies and revenue is the basic criteria used for identifying reportable segments. The sample firms score poorly in disclosing both mandatory and voluntary information. Profitability, listing status, external shareholding and proportion of independent directors positively affect the reporting practices of IT companies in India.*12/06/2015

Analysis of segment data *Refer Excel sheetSource: Annual Reports for AY: 2013-2014

InfosysTCSWIPROBusiness SegmentsFinancial Services and Insurance (FSI), Manufacturing (MFG), Energy, Utilities, Communication and services (ECS), Retail, Consumer packaged goods, Logistics (RCL)Life sciences and Healthcare (LSH).Banking, Financial Services and Insurance, Manufacturing,Retail, Consumer packaged goodsTelecom, Media and EntertainmentOthersIT Services:BFSI,HLS,RCTG,ENO,MFG,GMT2. IT Products3. OthersGeographic SegmentsNorth America, Europe, India, Rest of the WorldIndia, America, EuropeIndia, USA, Europe, Rest of the world

Analysis of Segment DataCase: Lucent Technologies and Roche*12/06/2015

Lucent Technologies and RocheRoches segment reporting is more oriented toward a line-of-business approach. The four segments reflect different businesses, product lines, and customers. The segments are naturally delineated and are essentially four different companies operating under one umbrella corporation. The low level of intersegment transfers between divisions provides further evidence that Roche's Industry Segments are not significantly integrated. *12/06/2015

Lucent Technologies and RochePharmaceuticals, and Vitamins & Fine Chemicals division has the highest proportion of intersegment sales--less than 5% of its total segment sales. This low level of integration suggests that Roche's acquisitions were not undertaken to achieve synergies through vertical integration.

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Lucent Technologies and RocheLucent's segments:Note that all three divisions operate in the "telecommunications networking industry." The segmentation is based on Lucent's internal organization, primarily focused on customer base and market segments rather than product type or technology. Consistent with this, we find that Lucent's intersegment sales arc significant. For the MCT division, they equal 20% of total divisional sales

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Lucent Technologies and RocheUsing the 1999 data, we note that each company has a dominant segment measured by sales and operating income. For Lucent it is SPN (62% of sales: 84% of Operating income); for Roche it is pharmaceuticals (60% and 69%). These dominant segments are also the most profitable. Each has the highest operating margin and ROA in their respective companies.

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Lucent Technologies and RocheThese patterns change when we move to the "secondary" segments. In Roche's case. Fragrances & Flavors, the smallest "contributor" to sales and operating income has the second highest operating margin and ROA.

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Lucent Technologies and RocheFor Lucent, the differences are more striking. Although MCT segment sales were one-third below the Enterprise segment (14% versus 22%), its contribution to Lucent's operating income was 50% higher (17% versus 11% of total operating income). Consistent with the above, MCT's profitability ratios (operating margin and ROA) are significantly higher than those of Enterprise.

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Analysts pointThese differences should be viewed in conjunction with the three-year growth in sales, Operating income, and assets of these segments:

See the data on growth

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Lucent Technologies and RocheThe three year trend in sales and operating income mirrors the 1999 levels of these variables. Again SPN is the best performer; operating income increased 201% on a sale increase of 51%. This indicates leveraging of operating efficiencies and increased return to scale, justifying the increased investment in that segment as reflected by growth in (identifiable) assets. A similar pattern emerges in the MCT segment; a 28% Increase in sales translates into a 72% increase in operating profit.

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On the other hand, as indicated earlier by its operating ratios, the Enterprise segment seems to be troubled. Although sales grew by 37%, operating income fell 8%. These data raise questions about the viability of the market in which Enterprise operates as well as whether the increased investment (56% asset growth) in that -segment was justified.

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Lucent Technologies and RocheThe additional disclosures made by Roche provide useful insights into segment characteristics. The segment liabilities are not proportional to segment assets; they are relatively highest for Vitamins (1/3 of assets) and lowest for Pharmaceuticals and Fragrances. Thus re-turns on net investment are highest for Vitamins *12/06/2015

Lucent Technologies and RocheThe R&D data show the highest investment for Pharmaceuticals (18.3% of revenue). While not surprising given the characteristics of that business, this ratio is a more useful comparison with other (pure drug) companies and comment on it.

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******Note: B- Required for comparison purpose.*Note: IAS 14 also classifies segments into (a) Business segment (b) Geographical segment.**Infosys: 2012-2013: BS: Financial Services and Insurance (FSI), Manufacturing (MFG), Energy, Utilities, Communication and services (ECS), Retail, Consumer packaged goods, Logistics and life sciences (RCL).

*Note: 150 Companies are taken for study. Only 45 responded. 37 firms listed in India and 08 firms are listed both in India and outside India.*Are they perfectly comparable? WIPRO-Industry segments primarily consist of Banking, Financial Services and Insurance (BFSI), Healthcare and Life Sciences(HLS), Retail, Consumer, Transport and Government (RCTG), Energy, Natural Resources and Utilities (ENU), Manufacturing and Hi-tech (MFG), Global Media and Telecom (GMT).*